No Monetary Policy Is Not Just Another Name for Fiscal Policy: The crux of Cochrane’s argument is that… inflation is typically the result of a perception by bondholders… that the government will not be able to raise enough revenues… [and resort to] implicit default through inflation…. [T]he expectation of future inflation because of an anticipated future fiscal crisis may suddenly — when an expectational tipping point is reached — trigger a “run” on the currency well before the crisis, a run manifesting itself in rapidly rising nominal interest rates and rising inflation even before the onset of a large fiscal deficit.
This is certainly an important, though hardly original, insight, and provides due cause for concern about our long-term fiscal outlook. The puzzle is why Cochrane thinks the possibility of a run on the dollar because of an anticipated future fiscal crisis is at all relevant to an understanding of why we are stuck in a lingering Little Depression. Cochrane is obviously very pleased with his fiscal theory of inflations, believing it to have great explanatory power. But that explanatory power, as far as I can tell, doesn’t quite extend to explaining the origins of, or the cure for, the crisis in which we now find ourselves.
Cochrane’s recent comments on a panel discussion at the Hoover Institution give the flavor of his not very systematic ideas about the causes of the Little Depression, and the disconnect between those ideas and his fiscal theory of inflation.
Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.
Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense.
The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.
Taxing the rich is the new hot idea. But do we have 9% unemployment-of anything but tax lawyers and lobbyists–because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?
The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because $1.5 trillion of excess reserves aren’t enough to mediate transactons?
I posed this question to a somewhat dovish Federal Reserve bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had three humors, not just one.
Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.
In sum, the patient is having a heart attack. The doctors debating whether to give him a double espresso vs. a nip of brandy. And most likely, the espresso is decaf and the brandy watered.
So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937-not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).
If so, the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”
Cochrane seems content to take the most naïve Keynesian model as the only possible macro explanation of the current slump, and, after cavalierly dismissing it, concludes that there is no macroeconomic explanation for the slump, leaving “get out of the way” as the default solution. That’s because he seems convinced that all that you need to know about money is that expected future fiscal deficits can cause inflation now, because the expectation triggers a “run” on the currency. This is an important point to recognize, but it does not exhaust all that we know or should know about monetary theory and monetary policy. It is like trying to account for the price level under the gold standard by only taking into account the real demand for gold (i.e., the private demand for gold for industrial and ornamental purposes) and ignoring the monetary demand for gold (i.e., the demand by banks and central banks to hold gold as reserves or for coinage). If you looked only at the private demand for gold, you couldn’t possibly account for the Great Depression.
PS I also have to register my amazement that Cochrane could bring himself to describe Lucas’s Millman lecture as brilliant. It would be more accurate to describe the lecture as an embarrassment.